A recent New York Times article pointed out that the US Federal Reserve’s stress tests for banks have become more rigorous in recent years. What used to be a once-a-year, superficial test has evolved into a year-long process. When the program began, 150 employees were tasked with implementing tests and models – today that number stands at 600.
These stress tests are intended to measure banks’ resilience in the face of significant economic decline – as it did in the recent recession. In order to prevent banks from ‘gaming’ the system the Federal Reserve keeps its models a secret, meaning that financial institutions are not able to build certain portfolios to inflate their sense of stability.
While some bank officials have called this process subjective, the stress tests have had meaningful impacts. Citigroup – a bank that has failed to meet the Fed’s expectations twice in the past three years – has allocated more resources and employees to make sure that the bank passes. Similarly, Zions Bancorp made necessary precautions to reduce collateralized debt after failing the test last year.
All of these tests have a positive effect on expectations for the economy. As more banks pass these tests – or pass them with greater success – expectations for the economy become more optimistic, which in turn compels greater economic production. By implementing this program (and strengthening it) the Federal Reserve has created a simple and relatively low-cost means to achieve greater economic stability.
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There’s a simple solution: force banks to maintain more capital. My hunch is that in fact that’s how many banks pass the stress tests: rather than focusing solely on lowering risks and hence pulling out of lucrative (or formerly lucrative) business lines, they instead (or partly) rely on keeping more reserves. A homework assignment: how larger were banking sector losses in 2008-9? What does that imply about the order of magnitude of the capital that a conservative bank ought to keep, in contrast to casino players such as Citigroup?
In any case, the background situation is that banks did not impose risk-adjusted equity requirements on them selves, or even properly assess the direct capital they had tied up in trading operations. The former is merely a restatement of “hold more capital” but the latter says weak controls were across the board. The latter says that fee-generating business (in contrast to the “traditional” loan-making business) was not properly controlled by management.
The financial crisis demonstrated that both were at issue: execs literally didn’t know what their trading floors were doing, and they certainly weren’t holding reserves against the risk of losses. The kindest interpretation is that they assumed losses in individual units were uncorrelated. Now that’s a silly assumption, so more realistically they were either incompetent or crooks (at best deliberately ignoring risks).
My sense of dynamics in trading organizations is that it’s a bit of both — those who are lucky a few times in a row will be misjudged as brilliant and get promoted. In a rising tide all face an incentive to take on a lot of risk, grasping at the flotsam and jetsam of markets, or get left behind, with fatal consequences to their career. So there’s a lot of pressure to ignore risks.
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